Guest Commentary: Claudia Buch

Untangling the risks of banks and governments will take more than a banking union

The European banking union raises high expectations. Its uniform prudential standards are intended to improve bank stability and boost financial market integration, and it is expected to untangle the risks of banks and governments. Yet the banking union alone will not be able to achieve these aims. Rather, it will need to be soundly anchored and augmented in three different ways.

First, the Single Resolution Mechanism (SRM) is designed to force private investors to participate in risks that materialise. But for this to happen, the new rules will need to be applied rigorously, and exceptions to the bail-in of creditors must be minimised.

Resolution authorities can exercise a degree of discretion which allows them to exempt private creditors from the bail-in regime if it is thought that a full bail-in poses a threat to financial stability. This exposes the authorities to a conflict of interest. The higher the losses assumed by private creditors, the greater the risk of potential negative effects impacting on the stability of the financial system. The lower the private loss absorption, however, the higher the costs for government budgets – and the lower the disciplining effect for investors as well.

The U.S. systemic risk exception model is of interest for implementing the liability principle and permitting as few exceptions from the bail-in of creditors as possible. Here, the principle of bailing in creditors can only be deviated from in systemic crises. Each deviation must be approved by a majority of the relevant decision-making bodies. This may be a sensible approach to strengthening the credibility of resolution regimes and to being capable of acting during systemic crises at the same time.

Second, credibly separating the risks of banks and governments requires further regulatory action. The resilience of credit institutions will be strengthened by the implementation of Basel III and the additional capital requirements for systemically important financial institutions. But this is not enough. We need to put an end to the preferential treatment afforded to government debt instruments. Sovereign bonds, like other bank exposures, need to be backed by capital. What is more, the existing limits on large exposures should be gradually extended to cover sovereign debt as well.

Third, the capital markets in Europe need to be nurtured and integrated. Cross-border investment allows opportunities and risks to be better shared. This strengthens the resilience of the financial system.

Comparison with the United States shows that equity holdings there are dispersed much more widely throughout the entire country than they are in Europe. If a negative shock hits an industry or a specific region, then this loss is spread widely beyond that region. The same applies to positive developments. Through dividends, equity investors participate directly in economic risk and in gains and losses. Creditors, on the other hand, are not exposed to losses – except in the case of insolvency.

The integration of the capital markets may have increased in Europe, but the ownership structures of many enterprises are nonetheless strongly national. Improved market integration is hindered by differences in national taxation and legal systems, by varying market practices and, not least, by political factors.

In short: the banking union is a major step forward for the euro area and a key building block for greater stability. Yet the banking union alone cannot resolve the challenges the euro area faces, which is why further progress and action are crucially important in the areas outlined above.